Momentum is one of the biggest and most omnipresent forces in financial markets. Its fingerprints can be found in stock returns, across geographies and between asset classes.
While I remain a die-hard bargain hunter, I confess that I'm fascinated by the strength and persistence of even the simplest momentum strategies. Perhaps the most common one is to buy financial assets that have gone up the most in the past year and sell (or even short sell) those that have fared the worst.
It's a strategy that has worked well for individual stocks according to money manager James O'Shaughnessy, who studied the phenomenon in his influential book What Works on Wall Street. He figures that the 10 per cent of large U.S. stocks with the best one-year returns went on to beat the market by an average of 1.9 percentage points a year from the start of 1927 to the end of 2009. On the other hand, the 10 per cent of stocks with the worst prior one-year returns subsequently underperformed the market by an average of 3.4 percentage points annually.
Momentum is also present when comparing stock markets in different countries. James Montier, in his book Behavioural Investing, looked at the returns of stock markets in countries included in the MSCI world index. A portfolio that tracked the top third of countries, based on their market's gains over the prior year, beat the index by a whopping nine percentage points annually from January, 1975, to March, 2003.
The situation is similar when it comes to asset class momentum, which I highlighted in a past column. I recently revisited the strategy to see if it had lost its potency. It had not.
The strategy looks at the Canadian experience with six basic asset classes: three-month Canadian treasury bills, long-term Canadian bonds, the S&P/TSX composite, the S&P 500, international stocks (via the EAFE index) and gold. The idea being to compare the returns generated by a diversified portfolio to that of a trend follower who puts all their money in the best performing asset class of the prior year.
The baseline diversified portfolio split its money equally into each asset class and rebalanced each year. It gained an average 10.4 per cent annually from 1971 through to the end of 2014 while experiencing a modest level of volatility.
Trend followers who flipped into the best performing asset class of the prior year, held on for a year and repeated the process managed to sprint away with gains of 18.7 per cent annually. The big gains came with an extraordinary amount of volatility, but much of it was upside-volatility, which few people complain about.
Momentum's dark side was also evident. Contrarian bargain hunters who moved into the worst performing asset class each year gained only 5.9 per cent annually. They also suffered from more volatility than the baseline diversified portfolio.
The momentum effect persists when an asset class is removed from the mix. Mind you, removing gold cuts the overall returns substantially because gold had a few very nice runs in the 1970s and 2000s.
For the record, the best performing asset class in 2014 (in Canadian dollar terms) was the S&P 500, while Canadian T-bills fared the worst. The same relative ranking holds today when you look at their returns over the past 12 months.
But before you rush to play indexing roulette, take a deep breath. It's a high-risk strategy that can be hard to stick with and could suffer from shockingly large declines. That is, it might blow a big hole in your portfolio. In addition, fees and trading frictions can turn a strategy that looks good on paper into a loser in practice.
For my part, I'm happy to stick to a more diversified portfolio that I can comfortably hold for a long time. But those with a speculative nature should check out what momentum has to offer.